By: Tamara Pow, Esq.
For anyone who is currently invested in real estate or is considering doing so, whether you intend on moonlighting as a real estate professional simultaneously with your day job, or transmitting away from your current profession into the field of real estate full-time, you may want to consider the impact of two tax cases recently decided this year by the U.S. Tax Court for how you conduct your real estate activity.
In order to qualify for tax deductions, real estate professionals often have to deal with overcoming passive loss rules by proving that they are indeed real estate professionals for tax purposes. This means that they spent over half of their “work hours” materially participating in their real estate trade or business during a taxable year, no less than 750 hours during a single, taxable year. In order to qualify as a real estate professional, one would have to satisfy any one of several tests that determine material participation first.
According to Section 469(h)(1) of the Internal Revenue code, “[M]aterial participation is regular, continuous, and substantial involvement in business operations.” A passive activity loss is defined in §469(d)(1) as “[t]he excess of the aggregate losses from all passive activities for the taxable year over the aggregate income from all passive activities for that year.” And a passive activity itself is defined by §469(c)(1) as “[a]ny trade or business or activity for the production of income in which the taxpayer does not materially participate.” According to the same section of the Internal Revenue code, rental activity is generally treated as passive, regardless of whether the taxpayer materially participates. In essence, being a real estate professional and materially participating in real estate go hand in hand: you must materially participate in order to be considered a real estate pro, or you are doing neither if the hours do not add up.
In the case of Jones v. Commissioner of Internal Revenue, Docket no. 19645-14S, whose summary opinion was filed on February 7, 2017, it was determined that §469(c)(7) of the Internal Revenue code was not applicable to the petitioner, Alvin Jones, so he was not qualified as a real estate professional and therefore was not entitled to deduct losses from his rental real estate activity. Mr. Jones was a resident of the state of Georgia, owned and operated Georgia First Insurance, LLC (“Georgia First”), and owned 10 rental real estate properties in 2011, and 11 in 2012.
Payroll records for Georgia First indicated that he was paid for 519.99 hours of work in 2011 and 173.33 hours in 2012. However, the hours on the payroll record for 2011 only reflected May to December and did not necessarily show the total time that he spent performing personal services for Georgia First, but rather just the extent of his compensation. Also not included were the working hours in connection to the reported business miles driven on behalf of Georgia First. In regards to the times spent on his rental real estate activity, the petitioner maintained contemporaneous time logs, claiming 951 hours in 2011 and 1,040 in 2012. However, despite these logs and the petitioner’s general testimony, the Court found that the petitioner failed to establish his total hours performing services for Georgia First due to the holes in the payroll records and the lack of other evidence to determine otherwise, making his claim to have spent more than half of his working hours on his rental real estate activity inconclusive, therefore sustaining the IRS’ disallowance of loss deductions, per §469(a).
Six days later, a similar case was decided with a different outcome in the same Court. In Zarrinnegar v. Commissioner of Internal Revenue, Docket nos. 23183-14, 15989-15 , the petitioner was a dentist who owned a dental practice with his wife. The petitioner’s contemporaneous time logs for both the dental practice and his rental real estate activity, as well as the testimony of several witnesses, including the petitioner’s wife, and the general testimony of the petitioner himself, were consistent in proving that the petitioner’s part-time schedule at the dental practice easily amounted to less than half of the petitioner’s working hours, while satisfying the condition that the petitioner work more than 750 hours on his real estate business during the year in question. Among other findings for additional questions presented to the Court in this case, the Tax Court determined that §469 of the Internal Revenue code did not disallow the petitioner’s deductions for losses from rental properties, reversing the original finding from the IRS in that matter.
So, consider your time commitment requirements carefully if you want to deduct your losses from investment in real estate. Passive loss rules can be beaten and rental losses can be deducted under the right circumstances, which may become easier as you reduce hours in your regular profession over time.